The decisions to make these rate cuts have not been unanimous, which raises the question: Why? To answer that question, we must understand the Fed’s role and its past policy decisions.
Congress has given the Federal Reserve two sometimes conflicting mandates: It should maximize economic growth and restrain inflation. The former apparently requires low interest rates; the latter, high ones. Walking that tightrope gives currency to the old saying that the Fed should “take away the punchbowl before the party really gets going.”
As we learned in the 1970s, high inflation — and expectations of high inflation — can devastate the economy. Low inflation — and expectations of low inflation — mean stable wages, interest rates and prices, all of which tend to encourage work, innovation and production.
The Fed’s strategy 1980s and ‘90s earned it considerable credibility as an inflation fighter. But the Fed has been less successful in responding to negative supply shocks, such as spikes in oil prices, that raise firms’ production costs and increase the risk of overall inflation. In response, firms must make structural adjustments — eliminate unprofitable products and change technologies to minimize cost increases. Those changes are often painful, especially for displaced workers.
In the past, the Fed responded to oil shocks by tightening the money supply, but that often led to recessions. Yet if the Fed had reduced interest rates to prevent oil‐shock‐induced output losses, it would have risked higher inflation.
The Fed’s past decisions to opt for money tightening probably reflected an extreme anti‐inflationary bias at a time when memory of the 1970s’ “great inflation” was still fresh. That memory seems fainter and less influential today, given the Fed’s dramatic interest rate cuts in the wake of climbing oil prices.
In the Fed’s defense, the current economic situation involves more than just an oil supply shock; the housing sector has weakened and the financial markets are suffering liquidity shortages. Declining home prices reflect over‐investment in houses, which compounds the negative oil price shock with a negative shock to Americans’ wealth and spending. Depreciating home values also cause lopsided bank balance sheets with too many non‐performing loans eroding bank capital. Those capital losses are triggering cutbacks in lending to viable borrowers who, in turn, reduce spending on consumption and investment.